2016 is the pivotal year for the music streaming industry. After years of growth, we can expect a market consolation for the new few months with mergers, acquisitions and insolvencies. Thus, the question arises which music streaming services will survive that consolidation process. I try to assess who will be the winners and losers by analysing the financials of several music streaming companies. In the first part of this series I examine the global market leader in the music streaming market, the Swedish music streaming company Spotify.

The Economics of Music Streaming: Spotify

Spotity Ltd. was founded in April 2006 by Daniel Ek and Martin Lorentzon in Stockholm, but its music streaming service was launched as a legal alternative to P2P music file sharing during the culmination of the Pirate Bay process in October 2008. Spotify is an interactive on-demand music streaming portal with a Freemium ad-supported tier and an ad-free Premium tier for £/US$/EUR 9.99 per month. The Premium subscription includes a better sound quality, an offline music mode and allows users to listen their music on mobile devices.

Spotify is currently available (April 2016) in 69 countries[1] with an active user base of 100 million in January 2016[2], with 36 million paying subscribers in July 2016.[3] In the financial year 2015, Spotify reported a total revenue of EUR 1.9bn, of which almost 90 percent (EUR 1.7bn) derives from paid subscription and 10 percent (EUR 200m) from advertisements.[4]

Despite the impressive revenue growth by almost 80 percent from 2014 to 2015, total costs and expenses also increase by more than 70 percent to EUR 2.1bn, creating an operating loss of EUR 184.5m. Thus, the annual loss further widened by 11.7 percent compared to 2014. [5]

The main cost drivers are the licensing fees payable to the rights-holders. Therefore, the cost of revenue, which mainly comprises of licensing expenses alongside customer services, payment procession and equipment costs, increases by 85.3 percent to EUR 1.6bn in 2015.[6] Thus, the cost of revenue is 83.5 percent of Spotify’s revenue in 2015, which means that at least 70 percent of the revenue is used to pay the rights-holders, maybe even more. This is a stable, but still pretty high share for three years now – remember that the cost of revenue share was more than 100 percent in 2010.

Nevertheless, Spotify is still between the devil and the deep blue sea. Spotify has to cut the cost of revenue to EUR 1.4bn or by 11.4 percent to break-even. This would result in a 74 percent share of the cost of revenue of the total revenue. Since the main part of the cost of revenue are royalty payments to the rights-holders, which by-the-way, own 20 percent of Spotify, this way of cost cutting is not very realistic. It also not very realistic to cut or at least freeze other expenses. The ongoing market consolidation and the fight for subscribers do not allow to cut R&D and marketing expenses. On contrary, we can expect a further growth of both cost positions.

Therefore, the only way out of the dilemma is to increase the average revenue per user (APRU). Spotify reported 89m active users at the end of 2015. 28m paid for the monthly subscription that resulted in an APRU of EUR 62.30. The APRU of the 61m Freemium users, however, was EUR 3.21. Thus, Spotify’s overall APRU was EUR 21.86 at the end of 2015. If we assume that the ad-revenue as well as expenses rose by the same a rate as from 2014 to 2015, the revenue from subscriptions has to increase to EUR 3.3bn at the end of 2016 to break-even. Since Spotify could add 2m subscribers in the second quarter of 2016, we can expect 40m subscribers for the end of the year. If Spotify can attract approximately 16m more Freemium users than in 2015 (the same growth as from 2014-2015), the number of active users would rise to 117m resulting in an APRU of EUR 31.62. However, it is unlikely that Spotify will increase the 2015-years-end APRU by 45 percent. Nevertheless, Spotify has to convert as many Freemium users as possible to paying subscribers to increase the APRU and to counterbalance the growth of expenses. Otherwise Spotify will continue to burn money and it is questionable how long venture capitalists will further bump fresh capital into Spotify. Spotify has already raised US $1.56bn in 8 rounds of investment to date from 26 investors.[7] The investors expect an initial public offering (IPO) in the near future to monetize their investment. In January 2016, Spotify promised investors a 17.5 percent discount on Spotify shares after a successful IPO within a year.[8] The stock markets, however, are still highly volatile and a hasty IPO bears the danger of destroying the company’s value.

In such a context, it is no surprise that Spotify launches a price promotion campaign offering three-month subscriptions for US $0.99 in the U.S. over the summertime. The campaign helps to raise the subscribers’ base and aims at increasing the still high conversion rate of 35-37 percent.[9]

Summary

Spotify is the global market leader in the on-demand music streaming market with still fast growing subscriber base.

Despite an annual revenue growth of 80 percent, the cost of revenue increased by more than 85 percent further widening the operating loss to EUR 184.5m.

Spotify’s business model relies on the conversion of the Freemium tier users to the subscribers on the one hand, but on the other on venture capital to prepare for an IPO.

Spotify has to become more attractive for the stock market by lowering the cost of revenue and by increasing the still high conversion rate.

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